I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

The Fiscal Cliff For Dummies, Part 2: The Economic Implications Of Extending The Bush Tax Cuts

U.S. Speaker of the House Rep. John Boehner (R-OH) addresses the media during a press conference in the U.S. Capitol building November 9, 2012 in Washington, DC.

Late last week, President Obama and House Speaker John Boehner began what promises to be two months of political posturing — and much less likely, meaningful negotiation — geared towards avoiding the impending “fiscal cliff.” I wrote about this much-discussed but little-understood cliff in the past, but now that the President has won reelection and Mitt Romney’s promised extension of the Bush tax cuts, elimination of the AMT, and removal of Obamacare are off the table, the fiscal cliff looms as a much more likely reality.

What follows is a detailed discussion of the cliff and its ancillary economic impacts. Let’s get to the Q&A:

Q: In your last post on the topic, you defined the fiscal cliff as “the convergence of two events on December 31, 2012 — the expiration of almost every tax cut enacted since 2001 and a scheduled reduction in government spending — that, if the experts are to be believed, when taken together will threaten to bankrupt America, shift the world balance of power, and knock Earth off its orbit, sending it hurtling through cold, dark space.”

While moderately entertaining, that definition didn’t really explain a whole lot. Can you help me understand how reduced spending and increased revenue could be a bad thing in light of our current deficit?

A: Sure. While going over the cliff would improve our current deficit by adding net inflows, according to the people who are paid to project this sort of thing, real GDP will drop by 0.5% in 2013 — meaning we would experience negative growth — and unemployment will rise to 9.1%. In other words, the fiscal cliff will kick-start a recession. The reasons why depend on which component of the cliff we’re talking about: the reduced spending or the increased tax revenue.

Q: Man, I’m still confused. Let’s start with the spending cuts….are they tied to the tax increases or are these two independent events?

A: It’s a little bit of both. While the timing of the two events are coincidental, there is no denying that at a minimum, the required spending cuts are indirectly related to the expiring tax cuts in the sense that the foregone revenue resulting from the cuts contributed to our bloated deficit, which in turn contributed to our need to cut spending. More directly, however, the changes in governmental spending are the result of the “debt ceiling crisis” of August 2011.

Q: I sort of remember that, but I was really preoccupied with the 4th season of “Jersey Shore” that summer. Can you fill in the gaps?

A: Sure. When the government wants to build a bridge, wage a war, or pick up some extra padlocks for Area 51, they need a way to finance the expenditure. In general, these funds come from one of two sources: tax revenue or borrowings.

For a number of years, the government has spent significantly more than it collected in tax revenue, forcing it to borrow the excess. And as you might imagine, consistently growing deficits and debt are a rather bad thing. Higher debt leads to a reduction in national savings, undermines investor and consumer confidence, and jeopardizes the government’s ability to continue to borrow at reasonable interest rates. Take these things together, and a fiscal crisis like the one experienced in Greece becomes a distinct possibility.

In light of these potential consequences, we can’t allow Congress to run amuck with the ol’ corporate credit card. As a result, there is a maximum amount of debt that can be incurred by the government, and this maximum is often referred to as the debt ceiling. During the summer of 2011, years of rampant spending finally caught up with the government, because it maxed out its borrowing capacity and run up against this debt ceiling.

Q: That sort of rings a bell. But we took care of all that, right? By the way, Season 4 was hilarious.

A: We did, but only in the most “U.S. government” sort of way. Rather than risk defaulting on our existing debt, we decided to raise the debt ceiling. Yes, you read that right….the government essentially punished itself for spending too much by increasing its ability to spend. Sound fiscal policy, right there.

But because Congress rightfully doesn’t trust itself, it built in a safety measure in the form of a bi-partisan “super-committee” — which isn’t nearly as cool as it sounds — that was charged with finding a way to cut $1.5 trillion off the national deficit over the next decade. In the event the committee failed to reach an agreement by November 2011, required spending cuts would kick in effective January 1, 2013, in an effort to slim our deficit and reduce our need for future debt. November came and went, and no agreement was reached. So here we are.

Q: Got it. So that’s where the spending cuts come in?

A: That’s right. And that’s also why I said that the expiring Bush tax cuts were indirectly responsible for the required reduction in governmental spending. The tax cuts reduced rates and expanded credits, which obviously reduced tax revenue and in turn drove up the deficit and the government’s need to borrow.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.

Tony, this is an excellent primer on the looming Fiscal Cliff! This is the first post I have come across that presents the facts clearly, without bias, and is simple enough for any American to understand. We have a long road to travel in order to fix our country’s financial problems! It will take people with bright minds who hold the best interests for all Americans at heart to resolve them. Thank you Tony, All the best, Holly Magister, CPA, CFP www.ExitPromise.com

So we are so far gone that cutting anything will put us in recession? & cutting nothing will kill us with debt?

How about this? How about we pretend like we are America, & tell the federal government that it needs a massive reduction in its workforce, & a pay cut for the ones left?

We can’t just pretend like we America, we don’t know how anymore. We the people are too far gone. & I mean the great vast majority of Americans, of course.

But here’s the thing, we can’t just do nothing. Somebody smarter than Obama & Boehner have got to go at this thing. “I don’t know” isn’t good enough. I suggest a lay off in D.C.. & huge pay cuts for federal employees.

They are the black hole anyway. Why not go for true viability. If you make pay reductions across the board, that is really the only option that will bring us a sustainable future.

I am sick & tired of governments that spend on themselves & simply extract more out of what they give back when things get tight. We have got to massively shrink them, not us. It is the most direct rout to recovery.

Problem is, the ones in charge are taking all that they can for themselves & constantly volunteering us to pay more, or get back are the exact same ones who need to be cut. Hello? Is anyone home in America?

This is the chaos that ensues when you run your nation by leaving the American People out of the decision making process. Fools in charge with nothing but stupid on top of stupid, covered with more stupid.

It used to be in America that our governments did as we said. Now, we just sit around & see how much less we’ll all get this time. Not working people.

Mr. Nitti, help me out here with a few things. Why do the democrats want to raise tax rates on those making over $250,000? Are they going to use that money to pay into the deficit? I think this is the real issue. I think Obama wants to take that money and spend it, and that’s why the republicans keep saying no.

DrJay, according to President Obama, he is looking for “economic patriotism” in which the rich would pay their “fair share.” I don’t know that this is the President’s official position, but my guess is that these funds would likely not be applied directly to reduce the deficit, but rather to fund Obamacare. And if he does intend to use the extra revenue to reduce the deficit, he will still need to curb spending since allowing the cuts to expire for the rich would raise only about $968 billion over the next 10 years, or roughly the equivalent of our 2013 deficit.

Good article, but I think you failed to point out the danger of the ballooning debt. If the bond vigilantes ever try to take the US to task by spiking interest rates and refusing to let us grow our debt pile (there is also only so much money in the world), we could within a very short timeframe be required to cut our spending by as much as $2T. That is about half the budget right now. How do I get the $2T, well we deficit spend over $1T, then the increase in the interest on our natoinal debt to 6% (a rate we paid in the lately 90s) gets you the rest of the way. This is a very real and possible outcome.

So given that the long term projections for our economy and unemployment are that going over the fiscal cliff is the best solution, the fact that the debt timebomb would be effectively neutralized should make it the right solution.

GGGL, my apologies, but I thought I pointed out that balooning debt leads to the need to fund interest payments, which further increases the deficit. It weakens consumer and investor confidence, which sends investment overseas. And if it continues long enough, it weakens the country’s ability to borrow at reasonable rates. All of these factors would make us prime for a fiscal crisis.

Great article. But this line “The tax cuts reduced rates and expanded credits, which obviously reduced tax revenue and in turn drove up the deficit and the government’s need to borrow.” is not obvious or correct.

Reducing tax rates does not “obviously” reduce tax revenue. Because decreasing rates stimulates job growth which in turn increases tax revenue. And you can decrease rates and cut out loop-holes and deductions.

The government’s need to borrow is independent of tax revenue. If you make $50K a year you don’t NEED to buy that shiny new Mercedes. If you CHOOSE to buy the Mercedes you are forced to borrow money. If you are fiscally responsible, then you don’t need to borrow because your revenue can cover your expenditures.

Obama had choices… let GM and Chrylser fail. Let the free market work freely. Close government agencies, like the Department of Energy, the Post Office, and a million other extraneous, obsolete branches. Stop foreign aid to terrorist nations. Stop granting money to companies like Solyndra and A123.

The deficit was not driven up by tax cuts. That is completely ridiculous. The deficit is driven up by stupid people. Stupid people can’t get jobs or don’t want jobs. They want free stuff, so they vote for Obama, who spends and spends to give it to them.

We use to import smart people. Immigrants used to be doctors, lawyers, professors, economists. These people came to this country and learned English. Changed their names. Adopted American culture and became Americans. Now we import the dumbest people on the planet. People that can’t read or write in their native language. People that don’t want to learn English. Don’t want to work or pay taxes. People that don’t want to pledge allegiance to America or adopt our culture. They just want free stuff. And now that we let them, the dumb, lazy people outnumber the smart, hard-working, taxpayers. And they elected Obama. And that is the DIRECT reason for the deficit.

Chimo, I understand and appreciate your point. Dropping tax rates does not necessarily lead to reduced tax revenues in the event the reduced rates get more people working, expose more people to the income tax, etc… I have not seen data quantifying the impact of the Bush tax cuts on tax revenue, but I’m sure I could find it in the IRS reports pretty quickly. Even if the cuts did decrease tax revenue, as you pointed out, the lost revenue was in no way “responsible” for our deficit, but from a purely mathematical standpoing, it would have “contributed” to it. I’ll see if I can find any firm numbers.